Why forgetting the Great Panic is not acceptable

Only 6 months ago, at the peak of the financial crisis, the world witnessed well over $30 trillion of its wealth disappear inexplicably. That came as a surprise to just about every banker or regulator, as none of them believed a general contraction of such severity was possible for our planet’s free-market economies.

Ironically, the real surprise is not that it happened, but that we still don’t know how it happened. Governments and economists everywhere are still perplexed as to how the global financial system sunk so deep and so fast. As the G20 nations prepare to discuss new banking regulations in Pittsburgh next week, the most critical element is still missing: consensus on the reasons behind the crisis. Without that, how can global regulations exist, let alone be effective?

But politics is a funny business: comprehension is always secondary to pleasing. It seems that debating compensation caps on bankers’ pay is more newsworthy than exposing the more complex reasons behind the panic, still shrouded with disbelief. Besides, with many of world’s stock markets now near euphoria, as manifested by their 30 to 60% rebounds in 6 months , why spoil the party? “Selective amnesia”, or the ability to choose not to remember that we still have many unanswered questions, is more comforting for most, even if temporary.

Yet, euphoria and amnesia form a strangely perverse blend: the more they mix, the more they feed on one another, until their combination is no longer possible. The excitement of euphoria, which is usually focused on the future, cannot co-exist with the embarrassment of amnesia, which is concerned with the past: until and unless reconciled, their combination is an unsustainable proposition.

Elusive causes and misconstrued effects

Anticipating that sooner or later some of these unanswered questions will surface again, revisiting some of the problems perceived to be behind this economic crisis, presents a fertile platform for reflection and learning. Let’s review some of them.

Pinning the problem exclusively on the U.S. subprime mortgages is naively biased, as it fails to explain the severity of this global economic contraction, reaching all the way to Russia. After all, the latter had apparently no banks exposed to subprime or to other toxic paper.

The “mispricing of risk” argument proposed by former Fed chief, Alan Greenspan, does not address the dangerous role that the “shadow banking” system — the non-bank financial institutions that defined deregulated American finance — played in this debacle. They, and not commercial banks with deposit-based and regulated lending practices, are behind the $7 trillion “debt bubble” which erupted in the U.S. financial sector.

“The failure of laissez-faire U.S. capitalism”, suggested by the former E.U. President Sarkozy, does not illuminate how Europe’s largest universal banks have also been so devastated. It is now widely acknowledged that, beyond the venerable U.S. investment banks – most of which could not survive - the practice of overleveraging was alive and well on both sides of the Atlantic : banking conglomerates like UBS, Deutsche Bank, RBS and Barclays, to name some, were keeping rivals like Bank of America, Citigroup and JP Morgan in good company.

It is increasingly clear that this economic crisis, although triggered by the US subprime mortgage problem, has its roots in world’s biggest credit surge in history. Simply put, many financial institutions everywhere have been allowed to create and lend a lot more money than reasonable, finally disrupting the delicate global balance.

Are there any lessons to be drawn ?

Well, who is it precisely that allowed this to happen: Governments? Central bankers? Regulators? Management? If lawmakers worldwide are expected to devise and implement lasting solutions, the answers cannot be ambiguous. It is in this spirit that I would like to point out three areas from which lessons must be drawn before attempting to craft new rules or regulations.

The first one is on the role and impact of an accommodative monetary policy. For world’s central bankers, that financial assets were ballooning away could not have been a secret. According to the Federal Bank’s own records, from 1997 to 2007, the US financial sector’s debt grew much faster than GDP to exceed $16 trillions. And, that is only part of the problem. Recognizing that the U.S. accounts only for about 20% of world’s GDP, the corresponding global excess scales up from there to more scary heights. Enough to make even those central bankers defying acrophobia take notice.

So, what have learned from this: should world’s central bankers avoid using cheap credit to prevent debt bubbles from forming? Most likely, but not without understanding the merits and pitfalls of the opposite force: expensive credit. As remarkably demonstrated by Paul Volcker in the past, independent tight monetary policy is salutary in curbing speculation and control inflation, but how will that play out now in a global scene where interdependence is the new norm? Can any large country now modify its monetary policy independent of the ramifications that it might have on its major trading partners and the valuation of its currency?

The second area for examination is the creation of debt overdose. Although much has been said about the U.S. investment banks and their pushing the capital-ratio limits beyond 30 with exotic and risky derivatives, this was not an exclusive practice. Over-leveraging was also eagerly embraced by Europe’s largest banks, known as universal banks. Whether it was because of their regulators who could not rein them in, or because of their management’s insistence that they should be exempt from capital limits, no one has so far claimed responsibility, let alone accountability, for what has now proven to be serious errors of judgment.

So, how can we introduce more regulations without understanding what should be a “permissible” leverage for financial conglomerates? If governments must stand behind entities “too big to fail”, then they have a duty to determine how much risk is reasonable to assume on behalf of their taxpayers money. The irony is that, contrary to recent arguments by some banking executives, this is not interfering with capitalism, but safeguarding its survival and prosperity.

The third area is on the governance model of publicly-held megabanks.Come to think of it, in these troubled megabanks, who or what was in charge of supervising the disproportionate allocations to real-estate, high-risk lending for oversized takeovers, off-balance sheet opaque bookkeeping and, finally, allowing a compensation system that begets uncontrollable risk taking? The answer is clear : their corporate governance system. Whether it is called a Board of Directors in the US, or a Supervisory Board in Europe, this is the place where the validity of the strategy, the accuracy of accounting, the quality of the performance and the adequacy of executive pay are supposed to be objectively and regularly assessed.

Yet, it seems that in the financial sector oversight has been divorced from accountability. Allowing high leverage to associate so closely with executive compensation — leading to dangerously destabilizing excesses on both fronts— points to at least malfunctioning, perhaps even regrettable corporate supervision.

Finally, one of the least understood lessons from the Lehman bankruptcy is the role of corporate governance vis-à-vis : a) shareholders - the purveyors of equity capital on whom banks depend to exist, more so than in any other business – and, b) the taxpayers -- providers of invaluable guarantees through government backing- , when things go wrong. Overlooking the pain inflicted on both shareholders and taxpayers while debating compensation limits on the so called “talent” that wrecked the system is neither reasonable nor constructive.

Learning from all three of the above areas will be critical in designing a more dependable and robust financial system. Failure to do so, as we have regrettably experienced last year, erodes confidence in banks, even among depositors, threatening capitalism at the core.

Moris Simson

The pathology of debt bubble(s)

The global financial crisis, although triggered by the US subprime mortgage debacle, has its root cause elsewhere: global debt overdose. Most explanations focused on irresponsible debtors and careless lenders, whether pointing to excessive borrowings by consumers or even by entire countries, tell only part of the story.

There is another facet to this crisis which has remained shrouded in mystery: the steady and imbalanced growth in the indebtedness of financial institutions among G8 nations. That is where the most worrisome overdose occurred: one with lasting implications for global financial stability.
Simply put, some of these banks or financial institutions have been allowed to borrow and lend a lot more money than reasonable, disrupting, in the end, the delicate balance in world’s credit markets. The level of global wealth destruction in the 18 months following September 2007, the beginning of the crisis, is historically unprecedented: $40 trillion.

In September 2009, one year after the cataclysmic demise of Lehman Brothers -- which triggered the largest convulsions in this crisis -- the majority of that staggering destruction still remains unexplained. Who is it precisely that allowed this overdose to happen: Management? Central banks? Governments? Something else?

If regulators worldwide are expected to devise and implement lasting solutions, the answers cannot stay ambiguous. After all, there is a limit to invigorating wobbling economies with national or regional stimulus financings, no matter how long and for how much: sooner or later, taxpayers of countries most affected by this disruption deserve solid answers.


A nation’s total debt

That consumers in America and Europe were both living beyond their means, and that perhaps the average household debt should have been capped not to exceed 120% of the average disposable income, is reasonably well understood and documented.

But it weren’t just consumers and households enjoying the foolish comforts of living on borrowed money; most governments among G8 nations were on it too.

That brings us to the notion of total indebtedness of countries, which comprises not just the loans held by its consumers and households but also, the ones held by its businesses, farms, governments and all its financial institutions. Economists measure the reasonableness of a nation’s total debt outstanding by comparing it to the size and growth of its GDP. Much like a consumer’s capacity to finance his loans with his future earnings, the comparison to GDP provides some insight into a nation’s ability to pay down its debt over time, helped by total economic expansion and productivity gains.

The national debt outstanding of the USA is an interesting place to start. The most prominent creditor nation some 50 years ago, now the largest borrower in the world,has a total debt outstanding nearing 350% of its GDP.

Although this ratio is not as bad as for certain European countries, the irony still remains that over the last decade the world has witnessed a record acceleration rate in the debt burden of its wealthiest economy.


Left unrestrained, such acceleration has a number of disquieting consequences ranging from abrupt credit contractions to alarming currency fluctuations. As already witnessed over the last 2 years, these are all destabilizing and can have dire consequences.


So what is it about the USA that got its total national debt into a “hockey stick”?





Dissecting the US debt “bubbles”

While from 1997 to 2007 the US GDP grew from $8 to over $14 trillions a few things happened to the make-up of American total debt. Some of these are well known and understood, some others are less so. Yes, there were debt-bubbles in the US over that decade, but not everywhere. The chart below, derived from data form the US Federal Reserve, graphically and unambiguously tells the story of these bubbles.

Household and consumer debt clearly formed a bubble, as it outpaced growth in GDP by more than $4 trillion for a number of reasons. Chief among them was the availability of low interest rates which allowed increased borrowings for purchasing homes but, also, for consuming more as well. Reckless lending led to subprime mortgages that allowed home buyers, who would otherwise never qualify, feed the speculative housing boom which also inflated other forms of consumption. But all that is well known and understood.

Surprisingly, in the same decade, corporate indebtedness has kept pace reasonably well with GDP growth. Although it outpaced it a little bit, it was not by an alarming amount. Perhaps this is because of the 2001 stock market crash. Following the crash, businesses of all sorts and sizes had started to exercise more prudence. With the exception of construction and real-estate companies, credit was reasonable, especially among technology companies who learned the importance of having manageable debt loads.

What is less known, and even less publicized, is that in spite of negative press coverage, government debt (including Federal, State and local) has lagged behind GDP growth. Despite the war on terror and unexpected tax cuts, the fact remains that talk about government deficits at all levels has been more successful in the political blame-game than in stimulating economic vitality during that decade. But, that is another and rather complicated topic which we are not going to address here.

Without a doubt, the financial sector debt has delivered the largest and the most disturbing of bubbles to the US economy. Had it kept pace with GDP growth -- instead of galloping ahead uncontrolled -- it would have risen closer to $9 trillion than the $16 trillion it ended up surpassing in 2007. The result? A $7 trillion bubble in 10 years, from a sector which includes all the banks and savings companies, but, also, other financial institutions ranging from insurance companies to retirement funds. On closer look to Federal Reserve’s statistical data however, it is the country’s “shadow banking” system — investment banks, securities dealers, hedge funds, mutual funds, and all other non-bank financial institutions that defined deregulated American finance — that contributed to inflate this bubble to unprecedented heights, and not regulated banking. Whether we call it excessive financial leverage or easy and reckless credit, the results are the same: economic instability and dislocations.

To-date, we have heard rumblings about grossly inadequate or blatantly inconsistent regulations, along with mistaken policies of abundant money supply. We have also heard about the lack of parsimony in the American consumer culture and the need to moderate the temptations of a credit society.

But what we haven’t heard in sufficient clarity yet is: who was ultimately responsible for overleveraging in the financial sector? Allowing overexposure to real-estate, jumbo loans for gigantic corporate takeovers, non-transparent bookkeeping, and, perhaps most importantly, a compensation system that begets uncontrollable risk taking, all have more to do with poor corporate governance than with the shortcomings of regulations.

It is increasingly obvious that both are intricately linked and perhaps even inseparable, but how are we going to address the issues if we don't start by recognizing that the notion of self-governance in banking has failed shareholders, employees and, ultimately, taxpayers ?